Bonds and Bottlenecks: Yield Slump Says Fed Right on Inflation. For Now.

Treasury bond yields are in their biggest retreat of the year this week, despite the fastest pace of inflation in more than decade. Does this mean the Fed is right when it says price pressures won't last? Maybe.
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U.S. Treasury bond yields are on pace for their biggest weekly retreat in more than a year Friday, as traders look through the hottest inflation data in decades and buy into the Federal Reserve's narrative that price pressures will ease as supply chain bottlenecks and labor market shortages ease over the second half of 2021. 

Core inflation, which strips out volatile prices in food and energy products, is rising at an annualized 8.3% clip over the past three months, the fastest since 1982. Headline inflation, in part powered by year-on-year comparisons in food and energy, is running at 5%, the fastest in more than 13 years.

Under ordinary circumstances, bond yields would rise quickly in face of such compelling inflation signals, as investors lower Treasury prices to reflect the erosion in value of future coupon payments. Benchmark 10-years notes rallied to a three-month low of 1.43% yesterday, however, as economists looked at the impact of supply-chain bottlenecks and labor market shortages -- both of which are expected to ease as the global economy fully exits the coronavirus pandemic later in the fall -- on current price increases. 

Is the bond market right? 

Well, its certainly more difficult to read signals from the $20 trillion pool of U.S. Treasuries these days, particularly now that the Fed's balance sheet has topped the $8 trillion mark for the first time in history, a figure that's nearly double the total it held before escalating bond purchases at the peak of the pandemic in March of last year.

But digging into the May CPI report does seem to suggest at least some of the Fed's "transitory" inflation narrative holds water: used car prices, which surged 7.3% last month, won't continue rising forever, nor will airline fares, which are jumping amid an uptick in leisure travel that simply isn't being match by demand from higher-margin business customers.

"Once the dust has settled and the details of the report have been digested, we expect policymakers to react to the number in much the same way as they responded to the April CPI," said Ian Shepherdson of Pantheon Macroeconomics. "That is, the leadership will argue that the spike in inflation will prove 'transitory' or 'transient' due to 'bottlenecks', which will fade or reverse over time, allowing inflation to subside to the target without assistance from higher rates."

"(Fed Chair) Powell and his colleagues, however, have never explicitly stated how far inflation would rise as a result of these 'bottlenecks', or how long it would take for the month-to-month CPI and PCE numbers to return a sustained pace consistent with the 2% year-over year target," he cautioned. 

 So where does that leave markets? 

"Nobody knows how to trade inflation," Bank of America noted in its weekly "Flow Show" report. "Everybody knows how to trade 'don't fight the Fed'."

Weekly inflows into bonds, the report said, jumped to $12.5 billion, compared to $1.5 billion into stocks and just $700 million into gold. Overall allocations from its private client business, with $3.2 trillion in assets under management, indicate a record high 64.6% exposure to stocks, 18% to bonds and 11.1% in cash.

Wage inflation could certainly add to the market's concerns -- if not the Fed's -- with the most-recent JOLTs job openings data showing a record high 9.3 million vacant positions in the U.S. labor market, suggesting employers will need to boost pay even beyond last month's 2% increase to entice people back onto the shop floor.

And with China reporting the biggest surge in factory gate prices since 2008 last month, setting up the prospect of "imported inflation" in the coming months, and Germany posting a slump in May industrial output as result of supply chain disruptions, even as order books remained swelled with post-pandemic demand that manufacturers were unable to meet, growth and inflation dynamics remain finely balanced on the fate of bottleneck easing.

"While we are hesitant to call that the peak in inflation expectations given ongoing bottlenecks in supply chains, there was a distinct air of a “buy the rumor, sell the news” dynamic to us," said LPL Financial's Chief Market Strategist Ryan Detrick of the May CPI data. 

"The coming months will be telling, though, as we are now entering the 'show me' phase of the inflation debate where market participants will be increasingly anxious for the Fed to prove its assertion that higher inflation will be transitory," he added.